You've heard the adage that some stocks go up, and some go down. If you find a quality company that impresses you with its management, history, products, and background, you'll likely bet that the stock price will increase over time. In stock parlance, that's called "going long" on the stock.

But what happens if you find a company with crummy products, with pending SEC actions about accounting irregularities, and with half of the management team under indictment? Well, it's possible that you'll bet that the stock price will decline over time (assuming it hasn't hit rock-bottom already). In that case, you might want to take a "short" position on that stock.

By "shorting" a stock, you're betting that the share price will decline, and you'll profit from that decline. And if you decide to short the stock, there are some rather counterintuitive tax issues that you need to be aware of.

How it works
Selling a stock short means you sell the stock now, when the share price is high, and then purchase the stock at some time in the future when the share price has declined. So what you've really done is bought low and sold high -- you've just done it in reverse. If you've never made a short sale, the concept might seem strange to you: How can you sell something that you don't own?

You can't, which is why you borrow the shares that you sell. You borrow the shares from somebody else (usually your broker), promising to "repay" those shares of stock back to the broker at some time in the future. How will you make that repayment? When you purchase the shares in the future, you'll then immediately turn those shares over to your broker (or whomever else you borrowed them from), and your loan is repaid. Your position is then closed. If the stock declined in value during this time, you made money. If the stock price increased, you lost money.

But the fact remains that you'll have to repay this loan in stock. And the loan to you of the borrowed stock is a true debt -- make no mistake about it. So the only way to repay that debt is to eventually purchase the stock and give the stock back to your broker.

Well, there is another way: You can deliver stock that you already owned prior to entering into the short sale. But be aware that if you already have a long position on a stock (you currently own it) and then enter into a short sale on that stock, you could run afoul of the constructive sale rules. If you already own the stock, and then take a short position against that stock, you're using a gambit called "shorting against the box," and there are some rules that could bite you in the behind if you're not aware of them. You'll want to read our series on constructive sale rules before you enter into any type of short sale "hedge" transaction with stock that you own.

So, in order to keep any of the discussion or examples out of the realm of the constructive sale rules, we'll assume that all of the short sales will be "true" short sales, and none of them will encompass sales that short against the box.

An example
On January 10, you borrow 100 shares of Company X from your broker. You then sell those shares for $50 a stub. You receive $5,000 for the sale, but you have a debt to your broker and will have to repay those 100 shares to your broker. On March 25 of the following year, you see that the stock price has declined to $15 a share. You decide to purchase 100 shares of Company X at a cost to you of $1,500. You then return those shares to your broker, and your obligation is complete. You make $3,500 off the deal: You purchased the stock for $1,500 and you sold it for $5,000.

But what happens if your research was faulty, and shares of Company X increase to $65 a share, and you don't see a downturn in sight? You'll likely decide to purchase those 100 shares and remove yourself from the position. It'll cost you $6,500 to make the purchase. You'll then return those shares to the broker and you're done... except for licking your wounds. You'll find that your purchase price was $6,500, your sales price was $5,000, and your loss on the transaction was $1,500. Ouch.

Tax issues
So you've completed your short sale. Is the gain or loss that you recognize short term or long term? Since the transaction was opened for more than a year, you might think that your gain would be long term. But you'd be wrong.

Remember that in order for any gain to be long term, you must hold and own the shares in question for more than one year. In this case, however, the shares that you used to make the original sale were borrowed; you didn't own 'em. Somebody else owned 'em. They just let you borrow 'em. You owned nuttin' until the time that you actually purchased the shares. And those shares were sold prior to your purchase. You simply used the purchased shares to repay the shares that you borrowed. So the shares that you actually purchased were in your hands for a very short period of time, much less time than allowed by law to recognize a long-term gain or loss.

In any simple short sale, any gain or loss will be considered short term, regardless of how long the short position may have been open.

Related issues
When you make the sale portion of your short sale, it's a real live sale. And your broker will issue a Form 1099B to you indicating that the stock was sold. Don't panic! Even if your short position is open at the end of the year, you'll want to report the sale portion of the short sale in the year that the sale was made. That will allow you to reconcile your Schedule D transactions with the Form 1099B that you receive from your broker (which is exactly what the IRS computers will also do).

But if your position is still open at the end of the year, you'll have no tax liability on the short sale. You simply report the sale as such, with no gain or loss, and report the transaction as an open short sale. The instructions for Schedule D will give you the details that you'll need to allow you to report such a transaction.

What happens if you short a stock that pays dividends? The person from whom you borrowed the stock will want his dividend payments, and he'll look to you for those payments. When you make the payments, how do you treat them for tax purposes? They could be an investment interest expense, or they could be an adjustment to the basis of the shares that you use to close the short sale. To understand when to apply the rules correctly, read Dividends Paid on Short Sales.

Go forth, and use this newfound knowledge to benefit from stock prices that go both up and down!

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues. He understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. However, he'll be glad to help you compute your gain or loss when you finally sell a stock.